Thoughts on the Impending “Default Crisis”

This guest entry is courtesy of my good friend Xuan. She had some things on her mind regarding the default crisis and the debt ceiling. Talk about a perfect way to kick off August. Thanks, chau!

If you ever feel inclined to sign up for a course in monetary economics (and yes, it’s boring), the first thing you’ll learn is the history of the dollar. Let’s see. During the Revolutionary War, the new American government issued “Continentals” to pay for the war effort. That basically means the US government wanted Americans to hand over real resources–food, clothes, weapons, properties, labor for hire–in return for a currency called Continentals.

The Continentals were worth something–meaning you can hand over the currency to someone else and get an actual good or service in return–once the Americans beat the British. Americans apparently didn’t trust their new government that much because people did not want to hold Continentals. The Continentals became worthless, so much so that we now have the famous saying “[it isn’t] worth a Continental.”

During the Civil War, the Union and Confederate governments both printed their own currencies, again hoping to convince private households to hand over their goods and labor in exchange for currencies. As the war stretched on and it became more apparent that the South was not going to win, the Confederate dollar lost value. Inflation in the Confederate states spiraled out of control (the Union also had an inflation problem, but it was not as bad).

When the Great Depression hit in the 1930s, the U.S. was then on the gold standard (as were the major powers in Europe). The world’s economic powers attempted to deal with the depression by restricting international trade, in order to stop the movement of precious metals out of their countries. As the US tried to kick start its economy, it became apparent that the government was not going to be able to print currency (the purpose of which is to “spend,” or more precisely, to get private households to hand over labor and goods for paper) without additional gold to back it up. It dawned on the US government that it didn’t need to be on the gold standard; hence, FDR took the US off the gold standard in 1933.

The US returned the gold standard after World War II. An ounce of gold was worth $32 USD, which was the international standard. European countries held US dollars in their central banks, and the U.S. held gold (to back up the dollars). This monetary setup was known as the Bretton Woods system. High inflation and slower economic growth in the US in 1970 and 1971 caused panic in Europe and Japan. The rest of the world did not think the US government could back up their dollars with gold anymore. President Nixon agreed; he announced on August 15, 1971 that the U.S. was not trading gold for $35 an ounce anymore (yes, there were several attempts to devalue the US dollar). The US went off the gold standard.

So how did the US dollar remain the international currency until today? Well, people soon realized (and trust me, they had always known this!) the US dollar has value because it is backed by the faith of the US government. The US political system is stable. The US government is not going to collapse tomorrow. Our Constitution has been around for a while. When you wake up in the morning and go to work, you’re trading your labor for US dollars. But why do you take US dollars? Why not insist to be paid in Euro or Yen or Yuan? You know that you can always hand over those hard earned dollars to someone else, and s/he will hand you everything from food to shelter, from clothes to entry into a movie. In short, you take the US dollar because you know other people will take it. And everyone accepts US dollar because, ultimately, you expect the US government to be around.

What is the significance of having a government that “is around”? The answer is a stable government can do two things: 1) it can tax you, and 2) it can put you in jail.

Every year, the IRS imposes an income tax on you. You have to pay this tax and the failure to do so can land you in jail. So how do you ALWAYS pay your taxes? In US dollars of course! Even if you write the IRS a check, that check gets cleared at the Federal Reserve. The Federal Reserve settles all commercial banks’ accounts and the Treasury’s accounts in US dollars! This means that at some point, your tax obligations must be settled in US dollars. But there’s only one entity that can legally print US dollar: the US government.

If we analyze everything we’ve discussed so far, it seems fairly obvious that the US government cannot default because it’s spending too much money or printing too much money. Every dollar that the US Treasury puts into the economy will come back to the Treasury at some point in the form of paid taxes. There is no physical limitation to the US government printing and spending dollars. The only limitation that exists is when Americans start thinking their government’s days are numbered–i.e., a revolution is about to happen, leading to a new form of government, or some country is going to invade and take us over!

So what’s the deal with Congress talking about not raising the debt ceiling and defaulting? This is a self-imposed default, if it happens on Tuesday. It is the US government that has the capability to print more money and to spend more money to pay not just the debt but also to spur economic growth; however, it refuses to do so. It’s as if you can afford to fix that leak in your roof, but you refuse to do so (for whatever dumb reason). Or the time that you came home from some event and your clothes got dirty but you didn’t want to change into something new. Instead, you decide to continue sleeping in your dirty clothes.

So, yes, if you have always thought Congress is composed of crazy, incompetent people, you are correct. But hey, there’s always the 2012 election. You can always vote out your congressperson.

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